Similarities between LLCs and S corps
LLCs and S corps are each separate business entities.
LLCs and S corps have their own legal existence. And their existence is separate from the people who own them.
A corporation is formed by filing articles of incorporation with its state of incorporation. To be taxed as an S corporation it then has to file an election form with the IRS. An LLC is formed by filing articles of organization with its formation state. (If the member or members do not want it to be taxed under the default rules it will also have to file a form with the IRS).
Once formed both S corporations and an LLCs will have to maintain a registered agent, file annual reports, maintain good standing with states, comply with business license requirements, and so forth.
LLCs and S corps both provide limited liability.
Both LLCs and S corporations offer their owners limited liability protection. This is one of the main reasons to incorporate or form an LLC to own a business rather than owning it yourself.
Corporations and LLCs are separate business entities from their owners. The entities (not the owners) are responsible for the business’s debts, liabilities and obligations. The liability of the corporation’s shareholders and the LLC’s members is limited to their investment. If you run your business as a sole proprietorship or general partnership, then business creditors can reach your assets, even if those assets have nothing to do with the business.
Note: Owners of an LLC or corporation (S corp or C corp) can lose liability protection in certain cases. Read Piercing the corporate Veil: LLC & corporation risks to learn more.
See also C Corporations advantages and disadvantages.
LLCs and S corps both offer pass-through taxation
S corps and LLCs both offer their owners pass-through taxation when it comes to federal income taxation. Pass-through taxation means that business income and losses are not taxed at the company level, but “pass-through” to the owners and are reported on the individual’s tax returns. This avoids the “double taxation” imposed on C corporation dividends that are taxed at two levels: the corporation and shareholders.
Note: LLCs and S corps are governed by very different federal income tax rules, despite both being pass-through tax entities. They are not identical when it comes to how they are taxed.
Advantages of an LLC over an S corp
1. LLCs offer flexible management
One of the reasons many people prefer the LLC over the corporation is that there is more flexibility in how it is managed. For example, LLCs can be managed by the members or by managers. Corporations are managed by a board of directors. Corporation shareholders do not manage the business and affairs of corporations.
2. LLCs have fewer corporate formalities
Corporation laws (which, as noted, apply equally to S corps and C corps) contain more provisions regarding managing the company than LLC laws. For example, corporations must hold an annual shareholders’ meeting, directors’ meetings are required, proper notice must be given and minutes taken, and so on.
LLC statutes do not have such requirements, providing LLCs with greater operational flexibility.
3. LLCs offer greater flexibility in allocating profits and losses
Another advantage of the LLC is that there is greater flexibility in splitting up financial interests.* Owners of LLCs can allocate profits and losses disproportionately among owners.
An S corporation’s profits and losses must be allocated strictly based upon ownership percentage. If multiple LLC owners have different roles in the business, this option could be especially beneficial.
* An exception to this rule is if an LLC elects to be taxed as an S corp.
4. Simpler tax filings
For a solely owned business, an LLC, because it can be disregarded as an entity for tax purposes, also offers the advantage of being able to include your business income and loss on your Form 1040 individual federal income tax return. (In other words, business income is taxed on your individual income tax return as if you were a sole proprietor and your LLC does not have to file a separate return.)
This option disappears if the LLC has more than one owner and is taxed as a partnership. In that case a separate partnership return has to be filed with the IRS. (Although it is only an information return as the LLC does not pay taxes).
5. Pass-through taxation without S corp restrictions
A major advantage of the LLC over the S corporation is that it can provide pass-through taxation without having to meet the requirements of Subchapter S as long as it is taxed as a partnership.
In order to make the election to be an S corporation, the corporation:
- Can have only certain types of shareholders (e.g., individuals, certain estates and trusts, certain tax-exempt organizations)
- Cannot have more than 100 shareholders
- Must be a U.S. corporation
- Can have only one class of stock (but differences in voting rights are permitted)
The IRS restrictions never end. At any time, violating these rules will jeopardize your pass-through taxation.
An LLC can achieve pass-through taxation status by being disregarded if it has one member and by being taxed as a partnership under Subchapter K without any of the Subchapter S restrictions.
LLCs also offer more income tax choices in how you are taxed. Not only can it be disregarded or taxed like a partnership but by making an IRS election, you could have your LLC taxed as a C corporation or an S corporation. A strong caveat (and potential disadvantage) here is that if an LLC elects S corp taxation, it still has to satisfy all the S corp tax rules. Plus, states differ in how they treat the IRS election. It is strongly recommended that you discuss this decision with your tax advisor.
Advantages of an S corp over an LLC
S corporations have some advantages over LLCs. Because an LLC can also be taxed like an S corporation, these advantages are based mainly on the differences between corporations and LLCs in general.
1. Preferred by some investors and lenders
It can be easier for corporations to obtain outside funding. Some investors and banks prefer to invest in corporations than LLCs because corporations are generally better for recapitalizing and reorganizing over time as a business grows. Being a corporation is also still considered more of a status symbol.
2. Easier to convert to a C corp
Another advantage is ease of conversion of an S corporation to a C corporation. To convert from S corp status to C corp status simply requires the filing of a form with the IRS. As noted, the state corporation laws do not distinguish between S corps and C corps so there is no filing necessary with the state’s business entity filing office.
LLCs and corporations, on the other hand, are totally different entities. In order to go from an LLC to a C corporation, you will have to either merge the LLC into a corporation, enter into a statutory conversion or dissolve the LLC and incorporate.
3. Enables selling stock or going public
You may want to do business as a corporation rather than an LLC if you anticipate raising capital by selling shares of stock, seeking funding from venture capitalists or private equity funds, or by going public.
Conclusion
As you can see, both the LLC and the S corp have their advantages and disadvantages.
Between an LLC and an S corporation, there is no single choice that is always better for every business owner. The best option depends on each individual owner’s current needs and future plans. Working with a business professional is the best way to determine which business structure makes the most sense.
Ready to form an S corp or LLC? Contact our compliance specialists at CT Corporation today.
